Deere & Company (NYSE:DE) Q1 2023 Earnings Call Transcript

Deere & Company (NYSE:DE) Q1 2023 Earnings Call Transcript February 17, 2023

Rachel Bach: Thanks, Brent and good morning. John Deere completed the first quarter with solid execution. Financial results for the quarter included 20% margin for the equipment operations. While still far from normal levels, fewer supply chain disruptions enabled our factories to operate at high levels of production. Strong ag fundamentals remain €“ our order book still in allocation are full well into the fourth quarter and in some cases, full through the balance of the year. Likewise, the Construction & Forestry division continues to benefit from healthy demand with order books full into the fourth quarter and orders still on an allocation basis. Slide 3 shows the results for the first quarter. Net sales and revenues were up 30% to $12.652 billion, while net sales for the equipment operations were up 34% to $11.402 billion.

Net income attributable to Deere & Company was $1.959 billion or $6.55 per diluted share. Taking a closer at the individual segments, beginning with the production and precision ag business on Slide 4. Net sales of $5.198 billion were up 55% compared to the first quarter last year and up versus our own forecast, primarily due to higher shipment volumes and price realization. Price was positive by about 22 points. We expect price realization to be the highest early in the fiscal year due in part to model year €˜21 machines produced and shipped in the first quarter of 2022, effectively including two model years when compared to the first quarter of €˜23. Currency translation was negative by roughly 1 point. Operating profit, $1.208 billion, resulting in a 23.2% operating margin for the segment compared to an 8.8% margin for the same period last year.

The year-over-year increase was primarily due to favorable price realization and improved shipment volume and mix. These were partially offset by higher production costs and increased R&D and SA&G. Prior year results were negatively impacted by lower production from the delayed ratification of our labor agreement as well as by the contract ratification bonus. Moving to Small Ag & Turf on Slide 5, net sales were up 14%, totaling $3.001 billion in the first quarter as a result of price realization and higher shipment volumes, partially offset by negative effects of currency translation. Price realization was positive by just over 11 points, while currency translation was negative by nearly 4 points. Operating profit was up year-over-year at $447 million, resulting in a 14.9% operating margin.

The increased profit was primarily due to price realization and higher shipment volume, partially offset by higher production costs, R&D and SA&G. Slide 6 shows our industry outlook for the ag and turf markets globally. We expect industry sales of large ag equipment in U.S. and Canada to be up approximately 5% to 10%, reflecting another year of demand. The dynamics of strong ag fundamentals, advanced fleet age and low field inventory all remain. We expect demand to exceed the industry’s ability to produce for yet another year. For Small Ag & Turf, we estimate industry sales in the U.S. and Canada to be down around 5%. Within the segment, order books for products linked to ag production systems remain resilient, while demand for consumer-oriented products such as compact tractors under 40-horsepower has softened considerably since last year.

Moving on to Europe, the industry is forecasted to be flat to up 5%. Fundamentals continue to be solid, still moderating from recent highs and net foreign cash income remains healthy. In South America, we expect industry sales of tractors and combines to be flat to up 5% following a very strong year in fiscal year €˜22. Farmer profitability remains high as our customers benefit from robust commodity prices, record production at variable currency environment. And while the backdrop in the large ag is favorable, demand for low horsepower equipment softened a bit over the first quarter. Industry sales in Asia are forecasted to be down moderately. Now our segment forecasts, beginning on Slide 7, for Production and Precision Ag, net sales are forecast to be up around 20% for the full year.

Forecast assumes about 14 points of positive price realization for the full year and minimal currency impact. As noted earlier, we expect to achieve higher price realization in the first half of the year and then see it moderate a bit in the latter half. The segment’s operating margin is now between 23.5% and 24.5%. Slide 8 shows our forecast for the Small Ag & Turf segment. We expect net sales to be flat to up 5%. This guidance includes 8 points of positive price realization and less than 0.5 point of currency headwind. The segment’s operating margin is projected between 14.5% and 15.5%. Changing to Construction & Forestry on Slide 9, net sales for the quarter were $3.43 billion, up 26%, primarily due to higher shipment volumes and price realization.

Results were better than our own forecast for the quarter. Price realization was positive by over 13 points, while currency translation was negative by about 3 points. Operating profit of $625 million was higher year-over-year, resulting in a 19.5% operating margin due to price realization and higher shipment volumes, partially offset by higher production costs. C&F had several miscellaneous items that were positive to the first quarter results. The impact of these positive items was approximately 1.5 points of margin and we do not expect them to repeat. Prior year results include the impact of the lower production in the first quarter due to the delayed ratification of our labor agreement as well as the contract ratification bonus. Let’s turn to our 2023 Construction & Forestry industry outlook on Slide 10.

Industry sales of earthmoving and compact construction equipment in North America are both projected to be flat to up 5%. End markets for earthmoving and compact equipment is expected to remain strong. While housing has softened, infrastructure, the oil and gas sector and robust CapEx programs from the independent rental companies have continued to support demand. Retail sales have remained robust and dealer inventory is well below historic levels. Global road building markets are forecast to be flat. North America remains the strongest market, compensating for softness in Europe as well as in parts of Asia. In forestry, we estimate the industry will be flat as softening in the U.S. and Canada is offset with strength in Europe. Moving to the C&F segment outlook on Slide 11, Deere’s Construction & Forestry 2023 net sales are forecast to be up between 10% and 15%.

Our net sales guidance for the year considers around 9 points of positive price realization. Operating margin is expected to be in the range of 17% to 18%. Shifting to our financial services operations on Slide 12, Worldwide Financial Services net income attributable to Deere & Company in the first quarter was $185 million. The decrease in net income was mainly due to less favorable financing spreads. For fiscal year 2023, our outlook is now $820 million as the less favorable financing spreads, higher SA&G expenses, and lower gains on operating lease dispositions are expected to more than offset the benefits from a higher average portfolio balance. The less favorable financing spreads in both the first quarter results and outlook are a function of the velocity of interest rate increases and the lag in price changes.

Credit quality remains favorable with very low write-offs as a percentage of the portfolio. Slide 13 outlines our guidance for net income, our effective tax rate and operating cash flow. For fiscal €˜23, we are raising our outlook for net income to be between $8.75 billion and $9.25 billion, reflecting the strong results of the first quarter and continued optimism for the remainder of the year. Next, our guidance incorporates an effective tax rate between 23% and 25%. Lastly, cash flow from the equipment operations is now projected to be in the range of $9.25 billion to $9.75 billion. That concludes our formal comments. Now I’d like to spend a little time going deeper on a few things specific to this quarter. Let’s start with farmer fundamentals.

The USDA recently updated its farm income forecast. U.S. net cash farm income is forecast to be down in 2023 compared to 2022, but still well above long-term averages and at levels supportive of continued replacement demand. Importantly, crop cash receipts are predicted to be down only 3% and remain at very healthy levels for row-crop producers. And while expenses are expected to be up, some key inputs like fertilizers have moderated since peaking in 2022. All-in, the 2023 foreign income forecasts are solid and will continue to support equipment demand. This maybe specific to the U.S., but the message is similar across our various global markets, right. Brent?

Brent Norwood: That’s right. And I would add that global stocks to use remain very tight, keeping grain prices elevated, even if they are down a bit from the highs of last summer. So, the story here is one of slightly lower net income, but still quite profitable, which is true in most ag markets globally. As noted earlier, profitability in Europe remains solid. While grain prices have come off peak levels, input costs have also declined, keeping margins at supportive levels there. The relative profitability varies a bit by region with Central Europe faring a bit better than Western Europe, but overall, still solid across the region. And in Brazil, higher production and favorable FX has kept profitability solid, making the region one of the strongest from a fundamentals perspective. The political transition and rising interest rate environment could result in some softening for smaller ag equipment, but large ag equipment demand is holding steady.

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Josh Jepsen: This is Josh. One thing I’d like to add here is that when we meet with dealers, we hear consistent message from them, too. They are positive on the outlook and customer demand. We even get feedback they could quote more customers if they weren’t on allocation. So we feel good that the demand is out there. Our dealers are also optimistic about the level of tech adoption and demand for precision ag solutions as customers look to reduce expensive inputs, which improve profitability and sustainability. And this is not just a North American theme, but across the globe. I was with our dealers from Latin America earlier in the quarter and the appetite for increased technology from our customers is very strong and our dealers are investing heavily to deliver on the value proposition.

Rachel Bach: That’s good perspective on the industry outlook and the dealer feedback. With that in mind, our order books are generally full into the fourth quarter as we look across the global large ag business. Most orders are retail, so they have a specific customer name associated with them and we anticipate it will be another year where large ag equipment demand outstrip supply. But if we look more closely at our Small Ag & Turf division, the story is more. Can you step through that, Brent?

Brent Norwood: Sure. If we dissect the segment, around two-thirds of our sales are linked to products tied to ag production systems like dairy and livestock, hay and forage and high-value crops. The remainder is tied more to consumer-oriented products. So hay and forage and livestock margins remain above recent historical averages. Additionally, dealer inventory to sales ratio for midsized tractors are below normal levels. So this part of Small Ag & Turf has remained steady. A good proof point here is that the order book for our midsized tractors built in Monheim, Germany is filled well into the fourth quarter of fiscal year 2023. On the other hand, turf and utility equipment is more closely correlated with the general economy, specifically housing.

So we have seen softening there, particularly in compact utility tractors. This is one place where we have seen industry inventories build. And to round out the conversation on order books, Construction & Forestry is also full into the fourth quarter. Given levels of demand, we do not anticipate any rebuilding €“ any rebuilding of channel inventory in fiscal year 2023.

Rachel Bach: Let’s stay on that topic of inventory building and going back to your comment, Brent, on turf and utility equipment industry and inventories. Is that increase in channel inventory purely related to the softening in demand or is any of that seasonal for turf and utility equipment?

Brent Norwood: A mix of both. We are heading into the prime spring selling season for turf and utility equipment. So we normally have some inventory build at this time of the year that will sell-off as we go through the spring. But we are monitoring channel inventory closely, so we can react quickly if there is further softening in demand.

Rachel Bach: What about channel inventory for our other segments?

Brent Norwood: Yes. For large ag, our dealers remain on allocation as we have mentioned. The vast majority of orders are marked for retail and have a customer name associated with them. So, we don’t expect to see restocking of dealer inventory this year. You will see some channel inventory build seasonally a bit as we ramp up production ahead of the season, but we don’t predict much change in dealer inventory year-over-year by our fiscal year-end. We expect any restocking to be more of a 2024 story. And as I noted, it’s the same for our North America Construction & Forestry business. Dealer inventory is at historic lows. Based on retail demand and our production levels, we don’t anticipate much increase in dealer inventory. Again, we would expect any build there to occur in 2024.

Josh Jepsen: Maybe a couple of things to add here. As mentioned, our dealer inventories remain below historic levels as demand outpaces supply. We have noted a few times that our order books are still on allocation basis. And this continues because while supply challenges have eased, the supply chain is still fragile. It’s getting better, but we continue to experience higher-than-normal supply disruptions. We are working with our supply chain and doing our best to try to ensure delivery to our customers. Second, since new equipment inventories remain tight, our dealers are seeing the benefit in used equipment. Deals are turning their used equipment very quickly at a historically fast pace, demonstrating resilient demand for used.

As a result, used equipment inventories are at low levels and used equipment prices continue to be strong. This is a positive for customers as it reduces their trade differentials. This is especially true for both large ag and Construction & Forestry.

Rachel Bach: Thanks, Josh. Let’s shift to pricing. Production and Precision Ag in particular, benefited some high price realization here in the first quarter. This isn’t a normal comparison though. Josh, can you break that down for us?

Josh Jepsen: You are right. It’s not a normal year-over-year compare. It’s really comparing 2 years’ worth of price increases. Last year, during the first quarter, we were still shipping a fair number of model year €˜21 machines. We were behind on deliveries due to the work stoppage at some of our largest U.S. factories. So for example, a lot of tractors we shipped during the first quarter of 2022 were actually model year €˜21 machines and model year €˜21 pricing. During the remainder of fiscal €˜22, we experienced significant material inflation, but we also successfully increased line rates to catch up on shipments. So we shipped most of the model year €˜22 tractors during fiscal €˜22. So now here in the first quarter of €˜23, nearly all of the tractor shipments were model year €˜23.

So when one looks at the first quarter year-over-year price comparison is really model year €˜23 versus model year €˜21 or 2 years worth of price. We do believe the price comparisons will moderate in the back half of the year. Our full year forecast contemplates production cost increasing year-over-year due to the impact of labor, energy prices and purchase components, tough we do expect the increases to be at a much lesser extent than we experienced in €˜22. We expect to benefit from improvements in commodity prices, decreased use of premium freight and increased productivity as our operations run more smoothly. Looking forward though as inflationary pressures subside, we expect a reversion to our historical averages for price increases.

Rachel Bach: That’s helpful. Thanks, Josh. And also a good segue to talk about the rest of the year compared to the first quarter. It was a strong first quarter. However, in the first quarter, we had fewer production days with holidays and some planned maintenance, model year switchovers and so on. So as we look to the second quarter, we will have more production days. C&F, as I mentioned earlier, had some miscellaneous positive items in the first quarter that won’t repeat as we progress through the year. Brent, can you talk through how people should be thinking about our rest of the year forecast?

Brent Norwood: Absolutely. For PPA and C&F, we are confident in the rest of the year demand. And it’s likely that our seasonality for the remainder of the year will look more like our historical cadence with the second and third quarters expected to be the highest in revenue for PPA, for example. The supply chain needs to continue to improve, enabling higher production rates. Part delinquencies and delays have abated, but have not returned to pre-pandemic levels or anything we would consider indicative of a healthy supply chain. Our guidance contemplates that we can procure the material we need to continue production at current daily rates. So with respect to top line guidance, we do not see significant demand risk for the rest of the year, but we do need the supply base to continue to execute.

When it comes to production costs, there are a few variables to consider. As Josh mentioned, while raw material prices and the need for premium freight have eased, we continue to see inflation on purchase components, labor and energy. So some puts and takes there. If the supply chain continues to improve, we could see some additional productivity gains in our operations.

Josh Jepsen: This is Josh. One, I want to point out that when it comes to costs, we are not just waiting for things to get better. We’re working with our suppliers to improve on-time deliveries and manage through inflationary pressures. We continue to look for opportunities to source differently when it makes sense, and we’re looking at our own processes as well to continue to improve efficiency and cost we can control. So cost is top of mind and a key focus area

Rachel Bach: One last special topic. We recently published our sustainability report. It can be found on deere.com/sustainability, and I would encourage people to take a look at it. Josh, any highlights you’d like to point out?

Josh Jepsen: Yes. A few things here to highlight. We made progress on our Leap Ambitions, including engaged, highly engaged, sustainably engaged acres. Engaged acres give us a foundational understanding of customer utilization of Deere technology, and we continue to enable our customers to use data to do more with less, unlocking economic value, while also improving environmental outcomes. We formed partnerships to accelerate this value unlock for customers. One example is a demonstration farm with Iowa State University, where over several years, we will be able to test various sustainable farm management strategies and farming practices. We will be able to collect data that mirrors our customers’ applications and decision-making to deliver better solutions.

We introduced the exact shot feature on planters at CES 2023. This is a great example of a solution that enables our customers to do more with less and leverages our tech stack, pulling nozzle technology from sprayers onto ExactEmerge planter to deliver starter fertilizer on the seed and only on the seed when planting. We also introduced a prototype of our first fully electric excavator at CES. It’s a Deere designed excavator with a Kreisel battery. It shows our focus on electrification in response to customer pull for quieter and safer solutions, while executing jobs in a lower emission manner, is an example of the team making progress on reducing Scope 3 greenhouse gas emissions for which we have validated science-based targets. With our focus on creating value for customers and being organized around their production systems, the solutions shown at CES underpinned the message of real purpose real technology with a real impact in all we do.

I also want to highlight the significant progress we made in terms of our operational sustainability goals. For example, Scope 1 and 2 greenhouse gas emissions, we had a goal of 15% reduction between 2017 and 2022. As we close out 2023, we almost doubled that achieving a reduction of nearly 29% during that time frame. So it’s not just our products, but our operations having a positive impact, too.

Rachel Bach: Thank you. That’s good stuff. And before we open the line for other questions, Josh, any final comments?

Josh Jepsen: Sure. It was a good first quarter. Strong results in start of the year. Fundamentals in demand across are solid across most parts of our business. The supply chain is showing early signs of improvement, but remains fragile, so the teams are managing through it. We’re proud of the team of employees, suppliers and dealers as we continue to work together to deliver our products and solutions to our customers. It was also very exciting at CES to reveal new solutions that will unlock value for our customers, not just economic value, but sustainable as well. You can read about it and the progress in the 2022 sustainability report, but to see it at CES and our strategy in action reinforces our belief that we have tremendous purpose and the ability to deliver real value for all those associated with Deere.

Rachel Bach: Thank you. Now let’s open the line for questions from our investors.

Brent Norwood:

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Q&A Session

Operator: Thank you so much. Our first question today comes from Seth Weber with Wells Fargo Securities. Go ahead please. Your line is open.

Seth Weber: Hey, guys. Good morning. I wanted to just ask a question on the cost side. Just to clarify what your message is on the input costs and freight costs and things like that. Are you suggesting that costs are going to continue to be up year-over-year through 2023? Or is there some point during this year when we start to see a cost benefit to Deere on a year-over-year basis? Like when does that flip, I guess, from whether it’s input costs or freight or what have you. Thank you.

Brent Norwood: With respect to production costs, Seth, there is quite a bit to unpack there. I mean I think and foremost, our factories were running a lot better in the first quarter, really better in the first quarter than at any other point in €“ over the course of 2022. So we were able to hit line rates that we were expecting to hit as well as completing the machines and the sequence that we intended to complete them on. With respect to production costs, they are still going to run higher on a year-over-year basis for the full year, but at a diminishing rate when compared to production cost increases that we saw in 2022. If I dissect the components of production costs, there is a few puts and takes there. Raw materials were slightly favorable in the first quarter, but that will get more favorable as we progress through the year.

Freight was already favorable in the first quarter as well, and we do believe that will continue rest of the year. Where we are still seeing inflation impacting the production cost line item for us is really in purchase components. and those tend to inflate on a lagging basis. If you think about the inflation that our Tier 3, Tier 2 suppliers are experiencing, it takes a while for that to bubble up into our production costs. So the inflation they have with respect to labor and raw are really hitting us on a lagging basis. That’s what’s driving some of the higher production costs year-over-year. I’d also note that labor and energy are going to be higher on a year-over-year basis, also taking production costs on an absolute basis up year-over-year.

Now that said, we are actively working with our suppliers to sort of get back any sort of inflation that’s linked to raw material. So you’ll see us very much focused on cost for the rest of the year.

Josh Jepsen: Seth, it’s Josh. Maybe one to add there is. Last year, as we saw this, we had €“ because of the way our price programs we work on early order programs, we had set price and then we saw inflation come through. So while we were price production cost positive in €˜22, it was just slightly positive. €˜23, we would expect that to be much more positive as we catch up a bit on the pricing side and start to see some of the increases come in. So that will be more positive in €˜23 than it was in ’22 Thank you.

Seth Weber: Thank you, guys.

Operator: Our next question comes from Dillon Cumming with Morgan Stanley. Go ahead please. Your line is open.

Dillon Cumming: Great. Good morning. Thanks for the question. If I can just ask a longer-term one. I think some of the concern out there in the market is just that we haven’t seen an ag cycle this long, right, over the last decade. But if you look at Deere’s own revenue growth profile, right, in the €˜90s and early 2000, there have been prior instances of your company seeing 7, 8 years of consecutive revenue growth. So I guess if you had to describe the current backdrop, right, demand outstripping supply, etcetera, would you say that we’re operating in a market environment similar to those years versus the more commodity cycles that we’ve seen over the last decade or so?